Lending Club Investing Strategies
Many investors are looking for advice and a Lending Club strategy to help them reduce the risk of defaults and thereby ensure a good return on their peer loan investments. There are many articles and blog posts with advice from investment professionals. While many of the principles are the same, there are some significant differences as well. More importantly, there is some information that we believe is inaccurate and may actually hurt your loan portfolio performance.
The analysis below looks at some of the advice available to investors as well as theoretical assessment of some criteria. In addition, our extensive analytic analysis is cited in order to help you determine the best way to evaluate loan investments. PeerLoanAdvisor.com has evaluated over 1,000,000 peer to peer loans in order to develop our proprietary loan rating system. We are happy to share some of our findings with you.
Lending Club Investing Strategies
The first step in developing your LendingClub investing strategy is to determine your risk tolerance. Risk tolerance is based on how concerned you are about the possibility of losing money on your investment. Investors expect a higher return on risky investments in order to compensate them for the additional risk. What makes an investment risky? Normally, it is the possibility of losing some or all or your investment. United States government bonds are considered safe investments because it is extremely unlikely that the United States government will be unable to pay interest on its debt.
LendingClub investors can adjust the riskiness of their portfolios based on the grade associated with each loan available to investors. Loans have a grade from A to E, with A being the least risky and E being the most risky. Risk averse lenders will normally select A and B grade loans. Investors with a high risk tolerance will likely select loans in the C to E grade range. Investors using LendingClub’s automated investing tool can choose to accept all grades (with the loans spread out across grades A through E) or they can set the mix of grades that they want their portfolio to reflect).
The second step in determining your investment strategy is to decide how to select loans for your portfolio. LendingClub provides dozens of pieces of information about each loan in order to help you evaluate the loan. Many of these data elements are very similar to others and most are not very useful in determining the likelihood of default. Even still, our research has shown that there are at least 25 characteristics that are significantly correlated with default rate. Of those 25, there are approximately 15 to 20 that are not highly correlated with each other. This means they should probably be included in the evaluation of the loan. However, where there is some correlation the weighting of the characteristic should be adjusted so that it (and the characteristics with which it is correlated) will not be too dominant a part of the evaluation process.
Most advisors provide their thoughts on several criteria for evaluating loans, including income, income verification, home ownership, joint application, credit inquiries in the last six months, and length of employment, for example. In general, this advice is based on common sense or a rational consideration of the possible significance of these factors. In a couple of instances there are advisors who claim to have done some statistical analysis. The extent of the analysis and the analytical process used is not discussed in these articles. Most, but not all, of the criteria commonly mentioned do have some degree of correlation with loan default. This tells us that the advice is on the right track and may be sound, however there are significant differences. Below we will explain some of these differences and what our research shows.
The final step in creating a Lending Club investing strategy is to remember that diversification is important. You should have at least 100 loans in your portfolio in order to minimize the impact of each default. It is better to have more loans with the minimum investment than to have fewer loans (even if you think they are high quality) in your portfolio.
In some cases, we have evaluated criteria and determined that they are correlated with default rates. The interesting thing is that the relationship is the opposite of what we expected. This is what we call a ‘counter-intuitive finding’. One example of this is home ownership. An investor might expect that people who own their home are more likely to pay back a loan than people who rent or have a mortgage. However, our research has shown that this is not necessarily the case. Surprisingly, other responses to this question, in conjunction with additional information about a borrower, indicate a lower likelihood of default.
We found several instances of counter-intuitive findings with commonly used criteria of Lending Club investors. This means that advice provided by some experts may actually result in higher default rates and lower returns on your P2P investments. Or, if the other criteria used are valid, then their positive effect will be offset to some extent by the misuse of one or more data elements. The bottom line is that certain criteria, while potentially helpful, must be used in the right way and along with certain other criteria.
Correlated Loan Characteristics
In addition to the findings mentioned above, we also determined that many of the available data elements are correlated with each other. For example, total_rev_hi_lim (Total revolving high credit/credit limit) and revol_bal (Total credit revolving balance) are highly correlated with each other. This type of correlation should be considered when determining which criteria to use in evaluating loans. While an investor may want to use criteria that have a high degree of correlation, they may want to ‘weight’ the criteria less than uncorrelated criteria. This technique may be considered for characteristics such as income and debt-to-income ratio or any characteristics having to do with current outstanding debt amounts, credit inquiries and late payments.
A small percentage of loans are issued to joint applicants, meaning there is more than one borrower in one application. Some advisors recommend investing in these loans based on the belief that multiple people paying on the loan means a lower likelihood of default. We do not necessarily agree with this way of thinking.
It is important to remember that personal loans are one of the last bills a person will pay. First to be paid are utility bills as those services are necessary every day. Of course, rent or mortgage will be a high priority. Auto loans are also considered vital. But what happens if a personal loan is not paid back? It simply goes to collection and damages the borrower’s credit. But the lights stay on, the phone still works, the home is still a home and the car stays in the driveway and is still running.
This payback hierarchy becomes very important when considering the potential for a personal loan to go into default. If joint borrowers depend on two incomes to pay bills then it is vital that both borrowers continue working. We will use some made up figures to show a possible theoretical reason why joint borrowers are more likely to default. If the odds of a person being out of work for an extended period of time are 3%, then the default risk associated with unemployment is 3% for a single borrower. If joint borrowers rely on both incomes to pay back a personal loan, then we must consider the odds of just one of two borrowers being out of work for an extended period of time. Simply probability tells us that the odds of either one (or both) of the borrowers being out of work is 5.91%. Therefore, the risk associated with unemployment can be as high as 5.91% for joint borrowers. It is true that some loans will still be paid if one of the borrowers is unemployed, however, you can see that the theoretical risk seems to increase for joint loan applicants.
You are probably wondering what the data for joint loan applicants shows. Unfortunately, there is limited data because the number of joint applicants is a small percentage of all loans issued. The analysis we have done supports the theory that joint applicants are more likely to default. However, due to the limited sample size and changing underwriting methods used by LendingClub, we do not use this data in our assessment of loan quality and do not consider it part of an optimal Lending Club investing strategy. Individual investors may choose to use this criteria in certain circumstances and it may be of value. However, we recommend being careful and selective with how it is used if you choose to do so.
Most experts agree that income and debt-to-income should be included in criteria for evaluating a loan. The data confirms that these are valid criteria. However, these experts do not agree on exactly how to use these characteristics. In the case of debt-to-income, cutoff points range from 20% to 30%. For income, recommendations range from $50,000 to $85,000. These are wide ranges and we can tell you that how these characteristics are used makes a significant difference in assessing the quality of a loan.
Many advisors recommend automated investment wherein LendingClub will invest your money as it becomes available (through deposits from you or payments on loans in which you have already invested). The upside to this method is that available funds do not sit in your account and are invested immediately, thus giving you interest accruals. Your money is almost always earning interest with this method, which we agree is a good thing. However, the downside is that you do not get to decide which loans make up your portfolio. We believe that selecting quality loans is far more important than keeping your money fully invested at all times. The effect on your annual return of having a small portion of your money not invested is minimal. However, the effect of having poor quality loans in your portfolio can be disastrous.
Another issue with automated investing is that investors who expect to get returns matching the averages for all loans may be very disappointed. Our belief is that skilled and professional investors will select the highest quality investment loans and fund them very quickly. This means that the loans available at any given time do not reflect the average loan. They are more likely to be of poorer quality. Therefore, when the LendingClub automated investment program invests your available funds it is selecting from a pool of loans that does not even reflect the average loan in terms of investment quality.
Type of Account
There is general agreement among experts that investing in peer loans via an IRA is the best strategy. In a regular account with LendingClub, interest earned is taxed as income, which is likely to be at a relatively high tax rate. Using an IRA defers taxes until retirement so the account can grow tax free for years or even decades.
LendingClub Investment Returns
What type of return can you expect from investing in P2P loans? As noted above, this depends in large part on your risk tolerance. According to statistics published by LendingClub, average returns for each grade of loan is as follows (for loans issued between Q1 2007 and Q4 2016):
Advisors on the web say that their portfolios have consistently earned 10%. Of course, recent loans will make the return higher than long term returns because loan default normally does not occur until 6 to 18 months after a loan is issued. That is why we used figures for loans issued prior to 2016.
Our research indicates that, with a moderate amount of risk and proper Lending Club strategy, an investor can earn between 8% to 12% on a diversified portfolio after actual and expected default rates are considered. Higher returns are possible with a riskier portfolio of loans.
Is LendingClub a Good Investment?
We believe that the Lending Club investor strategies supported by our research and loan ratings can help you achieve superior returns for your portfolio. Once you understand the basic concepts of risk tolerance and diversification you can begin selecting loans that you feel are highly likely to be repaid in full. While there is some good advice available on the internet we urge you to carefully consider all that you have learned and spend time determining your complete LendingClub investment strategy. Of course, we are here to help with our extensive research so please consider becoming a member at PeerLoanAdvisor.com.
The loan ratings provided by PeerLoanAdvisor.com is an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. Analysis on this site, including ratings, and and information provided are statements of opinion as of the date they are published and not statements of fact. Loan ratings are not recommendations to invest in any loans or to make any specific investment decisions. PeerLoanAdvisor.com assumes no obligation to update the loan ratings for content following publication in any form or format. Loan ratings and information on this site should not be relied on and are not a substitute for the skill, judgment and experience of the user and their investment advisors when making investment decisions.